In retirement planning, tidy assumptions may not apply

Gail MarksjarvisTribune staff reporter

Tom Rowan is five years away from retiring and struggling with the same question that arises for most Americans as they approach retirement: How much can retirees pull out of their savings each year, and still have enough money left to last a lifetime?

He's thought enough about his future to buy a retirement condo close to the gorgeous California beach that clears his mind.

But when it comes to figuring out how much money he will be able to safely withdraw from his savings year after year in retirement, he's not sure he's on the right track.

"I don't know beans about this," he said.

Although he's a financial analyst for an industrial company in Chicago, he knows he's not aware of all the elements he must consider as he attempts to gaze into his financial future. And he's skeptical of some of the popular advice that comes from brokers, because he knows they could have a vested interest in getting him to save and invest more than he'll need.

So when he recently read that financial planners suggest that people should remove no more than 4 percent to 5 percent of their savings a year to pay for living expenses in retirement, he thought it was way too conservative an approach.

"Assuming that the invested funds average a consistent 5 percent return, your savings would not only keep from running out; they would not go down at all," he said. "So why not remove more?"

It's a question that often trips up smart, conscientious people, said Jack VanDerhei a fellow at the Employee Benefit Research Institute research group.

The problem, VanDerhei said, is that as people eye their retirement savings they make tidy assumptions about the future that won't necessarily apply.

In particular, they focus too much on the present. They could live 30 years or longer in retirement. They figure their living expenses will stay the same as today even though inflation will erode the buying power of their nest eggs. They rely on average investment returns instead of the possibility that a bad break in the markets could undermine the growth of their money--or even lead them to run out prematurely. And they forget that health-care costs are rising faster than inflation, and that retirees often spend periods in nursing homes after illnesses or injuries.

"If you plan to take 5 percent out of your money year after year in retirement, and the second year you end up in a nursing home, all bets are off," VanDerhei said.

People can insulate themselves from the nursing home costs by buying long-term-care insurance, VanDerhei said, but the cost needs to be figured into retirement spending.

Ron Gebhardtsbauer, a senior fellow at the American Academy of Actuaries, said people may live longer than they think."People buy life insurance in their 20s and 30s to cover their families in case they die," he said. "Yet, the probability [of death at those ages] is only 1 percent."

When people consider the risk of longevity, however, they severely underestimate the effects, he said. "There's a 50 percent probability they are going to live beyond 85," he said.

That's why deciding to take a certain amount of money out of savings each year can have serious consequences. For example, consider the 65-year-old retiree with about $800,200 in savings, who decides to take $59,125 out of his nest egg the first year of retirement, and then boost the amount 2.5 percent a year to cover inflation. Even if the person earned 6 percent every year on the money remaining in investments, he would deplete his nest egg by age 83.

If there is no pension, he would have to rely on Social Security. But the average retiree has been receiving just over $1,000 a month in Social Security. On average, it replaces about 40 percent of the pay during their working years, but upper-middle-income people might receive only about 20 percent.

Financial planners say people need to try to replace at least 70 percent of their final income in retirement.

Realizing that Social Security alone falls far short of the money people need, Medina, Ohio, financial adviser Charles Farrell has calculated that people should have saved at least 12 times their last salary by retirement. Then, he said, they can remove 5 percent each year, adjust the withdrawal up each year to cover inflation, and be fairly certain the money will last for 30 years.

To get there, Farrell suggests people save 12 percent of their pay each year starting at age 30.

But people can be tempted to withdraw more than 5 percent when they are about to retire and see how little 5 percent is. At that level, a person with $800,200 in savings could remove only $40,000 during the first year of retirement and perhaps increase it 2.5 percent each year to try to keep up with inflation.

The 5 percent withdrawal rate also works only if the investor earns 6 percent a year on their investments--an approach that history shows is likely during the long term with about 60 percent invested in stock and 40 percent in bonds, Farrell said.

But no one can predict what investments will do. As a result, Rande Spiegelman, a financial planning researcher with the Charles Schwab Corp., urges people to remove only 4 percent a year. With that approach, the person with $800,200 in savings would have about $32,000 a year to start.

Even with that modest approach, Spiegelman said retirees can't be certain their money will last 30 years. Stocks and bonds behave very differently from year to year, and Schwab has run hundreds of scenarios through a computer to try to assess the future. Those calculations--called Monte Carlo simulations--suggest that if retirees remove 4 percent of their money a year from their nest egg, they have a 90 percent chance of not running out of money.

You can try these simulations to see how likely it is your money will hold up. T. Rowe Price offers a free Internet calculator that allows you to do simulations at www3.troweprice.com/ric/RIC. You can experiment with different approaches to investing, different nest eggs and various levels of longevity.

Before using that tool, try the Retirement Planner at www.bloomberg.com (look under "Investment Tools" and click on "Calculators") to see the nest egg you might accumulate during your working years, and the impact of an average annual investment return both during your savings years and retirement years.

For a quick view of what's behind the Monte Carlo calculations, consider an illustration provided by the Vanguard Group: Its analysts assume a person retires with $500,000 in savings, and removes 5 percent of savings the first year of retirement--or $25,000. Each year the withdrawal is adjusted higher based on 3 percent inflation.

A bad spell in the stock market hits the person just after she retires at 65. During her first year of retirement, she suffers a 10 percent loss on her investments. The next year, her investments lose another 10 percent, and the year after that she loses 5 percent. After that, the pain is over and she enjoys a 7.5 percent annual return.

Her savings would be gone 18 years into retirement, even though she stayed within the parameters of the 5 percent withdrawal rule.

If the market downturn had not hit her early in retirement, the outcome would have been dramatically different.

Say she started with the $500,000 nest egg. But instead of the market sinking, she earned 7.5 percent every year for nearly three decades. Then the retiree takes a loss of 5 percent on her investments in one year, 10 percent the next and 10 percent a year after that.

In this fortunate fluke of market performance, after 30 years of retirement, the retiree would have $351,503 remaining.

In both cases, the average annual return for the investments is 5.8 percent, almost the modest 6 percent assumption that financial planners often make when assuming it's safe to remove 5 percent annually from retirement savings.

The crucial difference in the scenarios, however, comes down to just one variable--when the losses on investments just happen to hit during a person's retirement years.